Investing in Single-Tenant Triple Net Leases?
Consider these 6 questions before you make your investment.
Many real estate investors are attracted to single-tenant commercial buildings occupied under triple net leases in which the tenant pays for some or all the costs of operating the building, including real estate taxes, insurance, utilities, maintenance and capital improvements. Although simple in concept and a very attractive investment, triple net lease properties can have pitfalls, so investors must do proper due diligence.
Here are several questions investors must answer as they consider any deal:
- What are my objectives?
- Where is the location of the investment?
- What type of triple
net lease is acceptable to me? - What are the criteria
for the tenant? - What type of building use is acceptable to me?
- Why is the seller selling the property?
Objectives
It is crucial to define your investment objectives. Your objectives may change as you receive more information and data about geographical areas, types of investment, lease terms and returns on investment. For example, one investor who focuses on currently occupied single-tenant Midwest properties defines his acquisition objectives according to the following criteria. Each acquisition must have:
- Occupation by strong regional or national tenants.
- An acceptable triple net lease.
- A positive cash flow.
- E-commerce-resistant retail businesses such as convenience stores, dollar stores and fast food restaurants.
- At least five years remaining on the lease.
Location
Location, location, location. That’s the age-old adage of real estate investment. Determining a good location for your investment is crucial.
For an investor seeking a high-density population area, the investment may be much more expensive. But, the rewards of rapid growth are often worth the high cost of the investment. Remember, too, that a downturn in the economy will have the most significant impact on these areas, ushering in rapidly decreasing values.
In lower density areas, the investment required is much lower and the returns are more stable. That’s because these areas do not experience the significant high values of rapidly growing areas, nor the significant lows during economic downturns.
Types of Triple Net Leases
When analyzing the triple net lease of a potential investment, think of the lease as the investment rather than the building. The two primary questions to ask when reviewing the lease are:
- Is the tenant responsible for all the obligations for the building, including real estate taxes, insurance, utilities, maintenance and capital improvements?
- Does the landlord/investor have any obligations for the building such as capital improvements (e.g., a new HVAC) or structural improvements (e.g., roof or foundation repairs or replacements)?
All triple net leases are not the same. It is imperative that you carefully analyze the lease to understand the risks and returns on your potential investment and determine which type of triple net leases are acceptable to you.
The types of triple net leases include:
Absolute Triple Net Lease or Bond Lease
This type of lease is the most attractive for an investor because the lease requires the tenant to be responsible for all the fixed and operating expenses for the building, including real estate taxes, insurance, utilities, maintenance and capital improvements.
Triple Net Lease
The type of lease you may see most is the Triple Net Lease, in which the landlord is responsible for all or some of the capital improvements of the building (e.g., HVAC, roof, foundation and walls).
Modified Net Lease
In this type of lease, the tenant pays for utilities, insurance and interior maintenance and repairs. The landlord is responsible for all the other obligations such as real estate taxes and capital improvements.
Gross Lease
It is not likely an investor would invest in a building with a gross lease. In a gross lease, the tenant pays only for the rent on the building, and the landlord pays for all the fixed and operating expenses for the building.
Some other issues and risk factors you’ll want to consider when analyzing the lease are:
- If there are escalators, are they a flat percentage increase? Or, are they tied to some local or national indicator such as “fair market rent” or a percentage return on capital based upon the value of the building?
- Is the term of the lease near its end?
- What is the perceived risk in the market in which you are investing?
Tenant Criteria
Possibly the most important question an investor must address is the tenant’s ability to pay and meet the terms of the lease. The capitalization rate (cap rate) is an indicator of the risk factor. The leases for more creditworthy tenants, such as well-capitalized national tenants, will have a lower cap rate, and less creditworthy tenants will have a higher cap rate.
Building Use
The categories of commercial real estate are:
- Office
- Industrial
- Retail
- Multifamily
- Hotels
- Undeveloped land
As discussed, some types of commercial real estate, such as multifamily and hotels, are management intensive. Retail and industrial are the uses most often acquired by investors.
You must also determine whether the use is a specialized use that may be harder to convert at the end of the term of the lease or in the event the tenant vacates the lease for any reason. Examples of specialized uses are restaurants and medical buildings.
Most retail spaces other than restaurants are standard in design and scope, and a reuse is more easily accomplished. The same is true for industrial use, which will often meet the requirements of any type of industrial user.
In conclusion, it is crucially important to do comprehensive due diligence when considering a real estate investment.
bill deegan
Bill Deegan has more than 40 years of real estate development, accounting, finance and sales experience. Deegan served as senior vice president of the New York State Urban Development Corporation, a major public authority in New York State with more than $2 billion in real estate assets, including more than 10,000 rental units. In the private sector, he participated in the development of single-family and resort properties in Central America, was involved in the syndication and distribution of real estate limited partnerships and real estate investment trusts and has consulted with several businesses on the implementation of business strategies designed to enhance shareholder value. Deegan maintained an active license as a certified public accountant for more than 30 years and is a graduate of Pace University in New York.
